Inventory Accounting for Schedule C

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Cost of Goods Sold, Materials and Labor for Creating Inventory

Warning: These pages are not intended as professional advice. They are presented "as is", reader beware!

If you are producing goods (the IRS calls this "real or tangible property") or if you purchased items for resale, they must be treated as inventory. The expenses for creating inventory go on the back of Schedule C, Part III, where ten lines are all it takes to establish the basis for your cost of goods sold. But before you start filling out the lines, it's important to decide whether you are using cash or accrual accounting. With cash accounting, which I use and strongly recommend for any self employed sole proprietor who qualifies, you take earnings when you get paid and expenses when you pay them. If you choose, or are forced into accrual accounting, you're going to want a pretty robust software package or an accountant to do your taxes. The government realizes that accrual accounting requires a ton of paperwork, so they offer a number of exemptions. The most important one is, as an individual tax payer, if your gross is less than $1,000,000 per year, you can do cash accounting. Note that gross is your total sales, not your profit. For eligible small businesses there's a $10,000,000 exception, provided you meet some conditions and work in certain industries. There's also an important blanket exception for qualifying creative artists and personal service corporations (employee owner). The details are found in Publication 538. One interesting note is that unlike estimated payments, where the IRS gives you a break your first year in business, you are expected to choose the right accounting method based on your projected sales trend even if you're new in business a few months.

If your business involves producing or purchasing and then selling merchandise, you need to report an inventory to account for it. It doesn't matter if you start and end the year with nothing on hand, you still need to account for the fact that you had income from selling tangible goods. I don't know how many small businessmen have given up and headed for the nearest accountant after reading that you must use the accrual method to account for purchases and sales, but that's only if you don't meet the exceptions I mentioned above. You need to account for inventory on a year-to-year basis, whatever your tax year is, and you need to be consistent about it. Your methodology should be based on whatever is standard for your field of business. The IRS allows a couple different methods of valuing inventory, I use the actual cost and FIFO (First In First Out) as being the simplest. Bigger companies may want to use LIFO (Last In First Out), but as the IRS states: "The rules for LIFO are very complex." LIFO does benefit businesses (hastens tax deductions) when prices are rising, but if we ever have deflation, FIFO will be quicker.

Merchandise that's suitable for sale isn't the only thing you account for in inventory. Raw materials, partially completed goods, and materials that will become part of the packaging are also accounted for in inventory. But any products you are holding on consignment and any goods you have on order but don't actually own yet aren't inventory items. Anything else that's deductible or depreciable in your business, including equipment that may be used to make the goods, is not part of inventory and would have be deducted on the front of Schedule C or depreciated on Form 4562. There are also special rules if you are importing merchandise from a relative overseas, so be careful.

Another complication involves capitalizing certain costs in inventory under the uniform capitalization rules. I can't imagine doing it without an accountant or serious tax software, as it involves assigning fractional costs from procurement or production to inventory items. Who wants to keep track of how much labor or shipping is capitalized into each widget that enters or leaves inventory? Fortunately, the same basic exception that applies to accrual accounting applies to uniform capitalization requirements.That includes resellers doing less than $10 million a year in sales, some R&D costs, creative expenses for artists, authors, musicians, and some other loopholes that you can read about in Pub 538. You'll see reference to both direct and indirect costs, which are a bit of a toss-up. Direct costs are things like the cost of raw materials and the pay for employees or contractors manufacturing the merchandise your business produces, while indirect costs are those that are necessary for the process but at an arms length.

The purpose of inventory accounting is to determine the cost of goods sold so it can be deducted from your gross sales on the way to determining your business profit as a sole proprietor. You start by choosing the method to value the closing inventory for the year: cost, the lower of cost or market value, or any other method the IRS will accept for your particular trade. Next you answer the question as to whether there have been any changes during the year in how you determine the cost of opening or closing inventory (I always answer no). If the roof leaked and it all got damaged, you might answer "yes" here and attach a note to explain that you're making some merchandise down to salvage value.

Next they ask for the inventory at the beginning of the year. This is the dollar value, not an accounting of six red ones and two blue ones, everything gets lumped together on the one line. If you weren't in business at the beginning of the year and aren't carrying over inventory from some older business, you didn't have an opening inventory and would enter "0." In the next line, you list the cost of your purchases during the year (to be added to the opening inventory), minus the cost of the items you took home for the kids. Next comes the cost of labor, but this never includes yourself, because as a sole proprietor, you're self employed, never an employee. If you don't meet the exemptions we talked about above, this labor cost will get capitalized into the cost of goods, but in that case you're making enough money to hire a dozen accountants. Materials and supplies is where you list the cost of all the raw materials and other necessary expenditures that go out the door with the finished merchandise, like tape to close boxes.

The inventory expense for "other costs" is a little tricky, because in addition to shipping costs to you and packaging purchases, it can also include the overhead for your manufacturing area. It's a bit of a hassle for a self employed person working out of the home to start divvying up the overhead expenses for utilities, rent, etc, between general business expenses and manufacturing expenses, but that's how it's supposed to be done. Finally, you do an inventory at the end of the year, and the closing inventory is subtracted from all of the other costs added together, which leaves you with the cost of goods sold that year. The cost of goods sold is what gets carried to the front of Schedule C and subtracted from your gross along with the other deductions.

Planning A New Business | Estimating Business Taxes | Schedule C Deductions | Car Expenses | Freelancer and Contractor Payments | Section 179 Depreciation and Form 4562 | Employee Benefits and Pension Costs | Professional Services, Business Taxes and Fees | Hotel and Travel Expenses | Deducting Food and Entertainment | Inventory and Cost of Goods Sold | Sole Proprietor Statistics | Home Office Deductions | Self Employment Tax | The Self Employed Sole Proprietor